Perversion of securities safe harbours

for Ponzi schemes in bankruptcy

Since 2005, a variety of securities-related transactions have been insulated from the effects of US bankruptcy law in order to safeguard the seamless operation of inextricably intertwined worldwide financial markets. A recent pair of decisions from New York concerning the fallout from the Bernie Madoff Ponzi scheme demonstrates the danger of perversion of these safe harbours when courts glide over essential statutory details.

In September 2011, the District Court for the Southern District of New York applied these safe harbours to eviscerate the Madoff trustee’s effort to recover $1 billion from the owners of the New York Mets baseball team.

The trustee argued, consistent with ordinary bankruptcy law, that the Mets owners had received years of payments from the Madoff Ponzi scheme in “fraudulent conveyances” that should be returned for the benefit of the defrauded victims of Madoff’s scheme.

The trustee argued that the payments were both actually fraudulent; that is, made with actual intent by Madoff to defraud the other investors in the scheme; and they were “constructively” fraudulent; that is, made while the Ponzi scheme was insolvent and the Mets owners had not invested “reasonably equivalent value” in exchange for these payments.

A combination of federal and state law allowed the trustee to seek to recover the $1 billion in payments made to the Mets owners in the six years before the Madoff scheme collapsed into bankruptcy.

The District Court gutted these arguments, seizing on the safe harbour for “settlement payments” related to a securities contract . The court concluded that, since Madoff’s firm was registered as a stockbroker, the safe harbour provision applied, and the definition of settlement payment “clearly includes all payments made by Madoff Securities to its customers”.

It is an obvious sign of weakness when a judge resorts to using the word “clearly” in a ruling on a hotly disputed point like this one; the contrasting ruling discussed below will reveal that this conclusion is anything but “clear”.

In any event, this ruling eliminated all but one claim by the trustee, based on actual fraud, and the actual fraud claim could reach only payments made within two years before the bankruptcy.

Thus, about two-thirds of the payments were insulated from recovery by the trustee on behalf of the victims of Madoff’s fraud.

Five days earlier, the Bankruptcy Court in the same New York district had issued a ruling in an almost identical case. The Bankruptcy Judge paid much closer attention to the statutory language and the unique context of the Madoff Ponzi scheme, however, and it ruled that the safe harbour for securities settlement payments most likely did not apply .

First, the Bankruptcy Court noted that, though Madoff was registered as a stockbroker, the law does not require the courts to accept this charade. The key term “stockbroker” is defined as a person “engaged in the business of effecting transactions in securities” .

The Bankruptcy Court observed that Ponzi scheme operators like Madoff often do not affirmatively make securities transactions on behalf of customers – the nature of the Ponzi scheme is that later investors’ money, not legitimate gains from securities investments, is used to make payments to earlier investors.

Thus, Madoff’s securities firm may well not actually qualify as a stockbroker, and might well not be entitled to the protection of the safe harbour at all, regardless of its purely technical and practically misleading registration as a stockbroker.

Second, the Bankruptcy Court expressed doubt that payments from the Madoff scheme qualified as “settlement payments” made pursuant to a securities contract. The definition of this concept may well be quite broad, but such payments must be made in the context of actual securities transactions.

Once again, if Madoff’s firm was not actually making securities trades on behalf of its customers, and it was instead simply taking the money of later investors and passing it on to earlier investors, this is not a transaction encompassed by the statutory safe harbour.

Not only does the statutory language likely not encompass payments made in connection with a fraudulent Ponzi scheme, the Bankruptcy Court noted, the legislative intent assuredly did not contemplate protecting such transactions. Indeed, it would subvert that intent to apply the safe harbours to fraudulent payments from a Ponzi scheme.

As a number of commentators have since observed, unwinding the fictitious trading activity of schemers like Madoff would likely have little or no effect on global financial markets. This fraudulent trading occurred quite independent of, indeed, standing as a ruse for, the legitimate securities markets.

The US Congress could never have intended to undermine public confidence in the securities trading system by insulating a fraudulent Ponzi scheme from the ordinary operation of fraudulent conveyance and bankruptcy law.

The Madoff trustee has signalled his intent to appeal the District Court’s ruling, which threatens to put more than $6 billion in other fraudulent payments out of reach for the victims of Madoff’s fraud.

Given the lack of scrutiny that the District Court “clearly” applied to the statute, and in light of the Bankruptcy Court’s careful and compelling analysis, one can only hope and expect that the Court of Appeals will overturn the District Court’s errant ruling.

Professor Jason Kilborn teaches business and commercial law at John Marshall Law School in Chicago. His primary focus is on the comparative analysis of insolvency systems for individuals, though his interest extends to international bankruptcy as well. He recently co-authored a book on international co-operation in cross-border insolvency cases, published by Oxford University Press.

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